Cybersecurity due diligence in M&A transactions has increased in importance as cybercrime has emerged as an increased threat many companies face.
When a buyer is acquiring a company, the buyer is acquiring all of the seller’s data or digital assets—such as customer data, trade secrets, know-how and business plans. These digital assets are subject to theft and destruction and may trigger compliance with cybersecurity and privacy mandates from regulators in the United States and overseas, which would subject a company to liability if such mandates are not complied with. As a result, today’s buyer risks acquiring a company whose data may have already been compromised or otherwise assuming liabilities for past noncompliance with cybersecurity and data privacy laws. This is why cybersecurity due diligence has increased in importance over the years.
The following are three key areas to consider in cybersecurity M&A due diligence:
1. Review of the target company’s current cybersecurity policies. First, the diligence team should try to understand the current cybersecurity practices and procedures the target company currently has in place. This cyber risk assessment involves interviews of key staff at the target company (e.g., risk officer, CTO, CIO, CEO) and a review of relevant documents (e.g., security programs and procedures, crisis management and incident response plans, reports of vulnerability assessments and responses to incident reports, vendor audits and any resulting remedial measures). In addition, the diligence team should focus on the maturity and suitability of the target company’s cybersecurity governance and vendor management, the terms of any cyber insurance policies, the existence of any past cybersecurity incidents and how such incidents were handled and whether the target company has interacted with regulators or law enforcement with respect to potential cybersecurity incidents.
2. Review of the target company’s network security conducted by an outside firm. If the target company has never engaged a third-party forensic firm to conduct vulnerability assessments and penetration testing, the buyer may want to retain a third-party firm to undertake its own cybersecurity risk testing on the target company’s network. Such testing could even include searches on the dark web to see whether the target company’s customer data or intellectual property is already compromised and available for sale. This cybersecurity risk testing typically involves a two to four week engagement depending on the situation.
3. Deal terms in the acquisition document. The representations and warranties concerning cybersecurity in the purchase agreement should be drafted to require the target company to disclose as much as possible about any potential cybersecurity violations and should be tailored to the target company’s industry and regulatory environment. In addition, the representations and warranties should cover compliance by the target company of applicable cybersecurity and data privacy laws, its own internal and external privacy policies and the absence of unauthorized access to the target company’s network.
Indemnities may also be used to hold the target company responsible for its representations and liable for hidden or undisclosed cybersecurity and data privacy liabilities that arise after closing. If the transaction involves an executory period in between signing and closing, the purchase agreement may include a covenant requiring the target company to implement ongoing safeguards of sensitive information during such period. Due diligence findings may also require the addition of certain tailored closing conditions requiring the target company to take steps to address noncompliance issues or to implement missing IT safeguards.
To conclude, M&A due diligence is important in uncovering and protecting against key risks in a transaction. In our data-driven economy, cyber risk must not be overlooked and should be included as standard M&A due diligence.
It’s a fact of life in the PE world. Negotiations can get tense. Even when the parties seem very well aligned – there is an eager seller who is ready for an exit, the parties have already negotiated a robust letter of intent that covers many of the major deal points, etc. – there is nearly always one or two points in the process where tensions rise and it feels like the deal could be in jeopardy. Whether it involves negotiating a purchase price reduction due to a less-than-optimal last minute due diligence finding, talking to a business owner about his role in the business (or lack thereof) following closing or another equally fraught deal-specific issue, there are things that you can do as a private equity professional to keep the deal on track despite these difficult conversations and optimize outcomes in the process.
So how can a private equity professional approach a potentially tense negotiation in order to keep a transaction on-track and achieve the best possible result? We asked our good friend, Jodi Coochise, a licensed psychologist and behavioral finance consultant and coach, to recommend her Top 5 ways to handle a tense negotiation in the PE space. Here are few things that you can do and keep in mind when dealing with a difficult topic in order to keep the negotiation grounded, focused and moving in a positive direction.
1. Set Clear Goals Ahead of Time. Establish a mutual goal before jumping into the negotiation. Often we assume this goal is self-explanatory or has already been determined. However, spending some additional time on this step at the beginning of the conversation can help set a tone of mutual respect and ensures there are no hidden agendas or expectations that might derail the conversation later.
2. Start with the overlap. When two people enter a negotiation meeting, they are primed to “fight” for what they believe to be fair. Starting a dialogue from this “fighters” mindset often results in tension and disagreement taking center stage in the conversation. Focusing on the differences also reinforces the attitude of being on opposite sides, which can make negotiating more difficult. It may seem counterintuitive to start the conversation on things the two sides agree on, but doing so fosters a tone of agreement and compromise that will be necessary once you get to the items that are likely to be stickier.
3. Don’t ignore the vibe. Pay just as much attention to the “mood in the room” as you do the content of the discussion. When we neglect our awareness of how others are responding emotionally we leave ourselves vulnerable to stumbling into a failed negotiation. As tensions build, people’s behaviors start to change. You might notice raised voices, people may cut each other off and start responding with flippant or sarcastic comments. These types of reactions can trigger defensiveness and anger and can derail a fruitful discussion. When you are able to monitor any changes in the tone or emotion of the room, you can take steps to reduce that tension before reactions boil over. You might suggest taking a break to let emotions cool, revisit the mutual goal established at the beginning of the discussion, or just take a deep breath to ground yourself. Remember that when our emotions run high we are less likely to think clearly, which interferes with the original goal of finding a shared outcome. When attention shifts away from the shared outcome, it can instead swing the focus towards “winning” or in some cases, “harming” the other person, which will likely not lead to productive results.
4. Remember that coercion is not the same as negotiating. It’s important to be mindful of when we are pushing too hard or trying to control the conversation. Cutting others off, speaking in absolute terms, asking leading questions, and using attacking statements are all ways we can be too aggressive and end up derailing a negotiation. By paying attention to these conversation-stoppers when they pop up, you can change course and work on asking open-ended questions, giving everyone the space to express their points of view and regain a tone of mutual respect.
5. Don’t underestimate the power of softening the message. Most of us have an internal alarm that goes off when it feels like someone is imposing their will on us. We instinctively react by digging into our point of view, pushing back with an equal amount of force or checking out of the conversation altogether. This is far from ideal when the hope is to reach a shared agreement. Softening your message slightly can help to re-engage the other person in the dialogue. You don’t have to change to a weak argument or abandon your perspective. However, by using statements like, “In my opinion…,” “It appears….,” or “I’m wondering if….”, you demonstrate that you are open for a dialogue and willing to hear another person’s perspective. Make sure to present things as your point of view, not as a universal fact.
Many thanks to Jodi Coochise for her contribution of this blog post. Jodi received her Ph.D. in Counseling Psychology from Colorado State University. She is a Licensed Psychologist who divides her time between a clinical practice and working in the financial industry. Jodi’s non-clinical work includes consulting with financial advising firms, where she provides coaching for advisors around integrating Behavioral Finance principles into their client interactions.
Check out Jodi’s prior post, Top 5 ways to approach negotiations with an emotional seller.
In New York State, there is a hot market for the purchase and sale of licenses to operate Certified Home Health Agencies (“CHHAs”) and Licensed Home Care Services Agencies (“LHCSAs”) because a moratorium on the issuance of new licenses by the New York State Department of Health (“DOH”).
Deals with LHCSAs and CHHAs are very similar to other M&A transactions, with the main difference being that title cannot actually change hands until final approval of the transfer has been obtained from the DOH. The approval process typically lasts about a year, but can last longer if there are issues with the application for approval. The crux of the matter is that timing is largely outside of the control of the parties. As such, there is a much longer delay between signing and closing than the typical time period for other M&A transactions.
Another distinguishing factor about these deals is that buyers often pay a significant portion of the purchase price upfront – sometimes as much as half, with more paid over time prior to closing – because the market is seller-driven. The combination of the significant upfront investment by the buyer and the long delay between signing and closing creates an interesting dynamic between a buyer that is eager to begin running and growing the business and a seller that is unmotivated to focus on the business, having already realized a large chunk of its return on its investment.
As much as a buyer may want to get into the business in order to revitalize it, protect its investment and start the process of turning a profit as soon as possible, legally, the seller cannot step aside and hand the business to the buyer until the closing has occurred, which requires DOH approval. Therefore, as title and the license remains in the hands of the seller, but the incentive to run the business lies with the buyer, the parties are at an impasse.
Buyers and sellers have contracted around this situation by entering into two consecutive agreements. In order to enable the buyer to start running the business and to free the seller up to move on to other things, the parties enter into a consultative agreement and a management agreement, whereby the seller hires the buyer to run the business during the time between signing and closing.
The consultative agreement is short-term and somewhat limited in the powers that it delegates to the buyer. The parties must provide notice of the consultative agreement to the DOH, which is useful because the unimposing notification requirement allows the agreement to go into effect immediately following the signing. The main purpose of the consultative agreement is to allow the buyer to transition to managing the business while the parties obtain approval of the management agreement.
The management agreement has a longer term than the consultative agreement, and it provides significant management power to the buyer, while reserving ultimate authority and responsibility to the seller. Once approved by the DOH, which usually takes a few months, it remains in effect until the closing is consummated, and title passes to the buyer. Under the management agreement, the seller hires the buyer as a manager, which gives the buyer generous power to run the business while the parties obtain approval of the overall transaction.
Under both agreements, the buyer/manager earns a fair market value management fee, which fee is paid out of the profits of the CHHA or the LHCSA. While any profits above the management fee technically remain the property of the seller prior to the closing, the parties typically provide that any such profits earned on the buyer/manager’s watch are set aside and pass along with the other assets or the equity of the company to the buyer at the closing.
This structure, which is composed of a series of agreements that create relationships between the buyer and the seller, accommodates the fact that there will be a delay between essentially buying the business and owning the business, while respecting the regulatory framework of ownership and management of such entities.
On May 23, 2017, the Association for Corporate Growth hosted a webinar on Cybersecurity for Private Equity – Strategies to Avoid Being the Next Cyber Target, which was presented by security experts Kaleigh Alessandro, Bob Shaw and Matt Donahue, each with Eze Castle Integration. The panel of security experts discussed today’s cyber threats, strategies to protect a company from cyber attacks, ways to mitigate vendor risk and the human factor involved in all cyber attacks.
The cyber threats that exist today will be different tomorrow, as this is an evolving and ever-changing landscape. Some current cyber threats are malware / ransomware, social engineering / phishing scams, espionage / cyber terrorism, hacktivism, insider threats and cybercrime. Any company that handles sensitive data is at risk, and may be a victim of, the foregoing cyber threats. If a private equity firm falls victim to such cyber threats, then it will face various risks including business, operational and reputational risks, regulatory risks and investment risks.
For a company to protect itself from cyber threats and cyber attacks, a company needs to implement layers upon layers of security across the company to protect itself from, and decrease the risk of falling victim to, a cyber threat. The main security layers are identify, protect, detect, respond and recover. There are various mechanisms that a company can implement to detect current weaknesses and protect against future cyber threats, including:
- Performing internal vulnerability assessments to determine weak links in a company’s network, which assessments should be completed at least on an annual basis;
- implementing technology safeguards (such as requiring strong passwords that are changed often, backing-up data, managing and implementing patches from Microsoft and other vendors, updating older operating systems, encrypting data and communication and having a VPN for remote access);
- having a written security policy in place which will be helpful when training employees;
- implementing a data governance platform so that a company can determine which employees access files and what such employees do with those files; and
- training all employees on the company’s policies and procedures around cyber security and on the most up-to-date security threats.
Cyber security detection and protection within a company should be ongoing and constantly evolving. With respect to recovery from a cyber attack, the response plan should be realistic and should involve internal staff across the board of a company, as well as outside counsel. A company should test its response plan by running through such procedures to make sure that employees are well-prepared for a cyber attack and that the response plan is achievable upon implementation. This response plan, like cyber security detection and protection, should be continuously updated and reevaluated.
A company should also mitigate vendor risk as much as possible by implementing a process or checklist for third party IT security due diligence, as a company needs to understand what weaknesses its vendors have and how such weaknesses are being addressed as well as the business continuity and disaster recovery plans that have been implemented by such vendors. In addition if a vendor’s IT security policies change, then the company should be receiving a notice with respect to such changes.
There is a human factor for every cyber threat, and a company should train its employees so that they are aware of the procedures and policies that are in place around cyber security. A company needs its employees to understand that they each have roles and responsibilities with respect to cyber security and they will be held accountable to comply with such roles and responsibilities to ensure that the company is protected from the ever-changing landscape of cyber threats.
Here at Nixon Peabody, we work on a lot of private equity-led M&A deals. We represent PE funds when they both acquire and sell their portfolio companies and, just as often, we represent business owners and strategic acquirers in their efforts to purchase or sell those businesses. There was a period of time several years ago where, almost universally, the M&A deals that we worked on (whether PE deals or strategic deals) would have require that a portion of the purchase price (very often in the 8% - 15% range) be set aside in a third party escrow in order to provide a pool of available cash to satisfy indemnification claims post-closing.
It seems, though, that times are changing. While every deal stands on its own and is driven by its own specific leverage profile and strategic objectives, my experience is that escrow percentages in PE-driven deals generally seem to be declining overall and some PE deals even seem to be coming together with no escrows at all.
Grateful to learn more about their recent experience in the escrow market, we recently hosted the team from Citi Private Bank’s Law Firm Escrow Group who shared with us their observations concerning escrow trends in M&A deals over the last couple of years. We asked Owen Ellsworth, a Director at Citi Private Bank, to share a few of these observations with our readers. Owen has also observed the impact that Rep and Warranty Insurance has had on deal escrows, particularly in the PE space. Owen tells us:
Rep + Warranty Insurance More Common in PE Deals: Within the Citi Private Bank portfolio, Rep and Warranty Insurance is most prevalent in deals that involve Private Equity sellers. Even within that subset of deals, I’d say that we tend to see Rep and Warranty Insurance used the most when transaction value falls within the $100 million - $250 million range.
Rep + Warranty Insurance Not a Factor in Purely Strategic Deals:
That said, when we narrow our view to purely strategic deals (i.e., those with strategic buyers and sellers with no Private Equity player), the use of Rep and Warranty Insurance doesn’t seem to come into play nearly as much and the escrow holdbacks in those deals are still in the more traditional range of 8% - 10% of total purchase price.
Rep + Warranty Insurance Lowering Escrow Amounts in PE Deals:
In our experience, Rep and Warranty Insurance has impacted escrow percentages in Private Equity transactions. In deals that involve a Private Equity seller, historically we would have expected to see anywhere from 8% - 10% of the total purchase price escrowed for indemnification purposes. However, with the use of Rep and Warranty Insurance, we now see that escrow percentage routinely decreased to approximately 1% of the purchase price, which is escrowed to provide for payment of the Rep and Warranty Insurance deductible. In some Private Equity deals, we are even seeing just an escrow for the purchase price adjustment, with no indemnification escrow being established at all.
Special Escrows Covering Items Excluded from Rep + Warranty Coverage:
Despite Rep and Warranty Insurance generally driving down escrow amounts in Private Equity deals, on the flip side we are also seeing certain transactions in our portfolio where “special escrows” have been established to deal with risks that are specifically excluded from coverage under the Rep and Warranty Insurance policy (e.g., IP claims in tech deals, healthcare (reimbursement) issues, environmental issues, etc.).
Many thanks to Owen Ellsworth and Citi Private Bank* for contributing this blog post! Owen Ellsworth is a Director of Business Development for Citi Private Bank’s Law Firm Group and is dedicated to working with top tier Law Firms to service their client’s escrow needs. Owen has over 15 years of diversified experience in financial services. Prior to joining Citi Private Bank’s Law Firm Group, Owen served as an Executive Director and Head of the North America Escrow Product in the Corporate and Investment Bank at J.P. Morgan. Prior to that, Owen was the Asia Pacific Escrow Product Head based in Hong Kong.
* Citi Private Bank is a business of Citigroup Inc., which provides its clients access to a broad array of products and services available through bank and non-bank affiliates of Citigroup. Not all products and services are provided by all affiliates or are available at all locations.
The views expressed herein are for informational purposes only and are those of the author and do not necessarily reflect the views of Citigroup Inc. All opinions are subject to change without notice.
There have been two recent changes to cybersecurity laws in the European Union, specifically relating to the use of personal data of E.U. residents, which are further summarized below. M&A professionals will need to keep these two laws in mind when (a) a target company uses the personal data of E.U. residents in its ordinary course of business or (b) a U.S. acquirer needs to access the personal data of E.U. residents during the due diligence process.
First, the Privacy Shield Data Transfer Pact (the “Privacy Shield”) was approved by the E.U. member states on July 12, 2016 and sets forth how companies established or using equipment in the E.U. can share the personal data of E.U. residents with U.S. companies. The Privacy Shield replaces the invalidated Safe Harbor program that was previously relied on by both U.S. and E.U. based companies to legally transfer the personal data of E.U. residents from the E.U. to the U.S. In addition to imposing stronger obligation on U.S. companies to protect the personal data of Europeans and mandating tougher monitoring and enforcement by the U.S. Department of Commerce and the Federal Trade Commission, the Privacy Shield also includes written assurances from the U.S. that any access to the data by law enforcement will be subject to clear limitations to prevent surveillance of European citizens’ data. For more detail on the specific requirements of the Privacy Shield, please see this NP Privacy Partner Blog Post.
One of the ways a U.S. company can be in compliance with the Privacy Shield is to complete a self-certification, which includes name and contact details of the recipient of the personal data, a description of the activities that will be completed with respect to the personal data received from the E.U., and a description of how the U.S. company is in compliance with the Privacy Shield. The U.S. Department of Commerce and the Federal Trade Commission have expressed their commitment to enforce the Privacy Shield and violations of the Privacy Shield can result in penalties of up to $40,000 per violation or $40,000 per day for continuing violations. More information on the enforcement of the Privacy Shield can be found at this website.
Second, the General Data Protection Regulation (the “GDPR”) is the next iteration of E.U. data protection laws and will be effective on May 25, 2018. The GDPR applies to all companies based in the E.U. as well as any foreign companies processing the personal data of E.U. residents. The GDPR is intended to strengthen and unify data protection for all individuals within the E.U. and requires companies to completely transform the way that they collect, process, securely store, share and securely wipe personal data. The changes that GDPR will implement include requirements for companies to appoint a data protection officer responsible for implementing and monitoring compliance with GDPR. In addition, companies will be required to implement privacy by design meaning that they must take a proactive approach to ensure that an appropriate standard of data protection is the default position taken when personal data is being processed. GDPR also includes a clear focus on data subjects’ consent to processing and accessing data, as well as requiring a data breach notification obligation to notify the E.U. protection authority of a breach without undue delay and, where feasible, within 72 hours. Companies must also notify the individuals where there is a high risk to the individuals concerned.
In the event GDPR is violated, then the penalties can be significant: for breaches, including security and data breach notification obligations, the penalties can be up to €10,000,000 or 2% of worldwide revenue, whichever is higher; and for more significant breaches, including consent violations and transfer restriction violations, the penalties can be up to €20,000,000 or 4% of worldwide revenue, whichever is higher.
Given the potential penalties for violations of both the Privacy Shield and the GDPR, M&A professionals will want to include in their due diligence of a target company an analysis as to whether the target company is in compliance with both laws. If the due diligence results conclude that the target company is not currently in compliance with the Privacy Shield, or that the target is not in compliance with the GDPR when it takes effect in May 2018, then these issues may require some changes to the purchase agreement, including the exclusion of certain non-compliance liabilities from the transaction, the addition of certain specific indemnities relating to such non-compliance issues, the inclusion of a covenant enabling for ongoing safeguards of sensitive information by the target company in between signing and closing, or the addition of a new closing condition requiring the target company to take steps to address non-compliance issues or the implementation of missing IT safeguards.
As a matter of course, a seller of a business includes a provision in a sale agreement to limit its liability to breaches of specific representations and warranties included in the sale agreement and not for representations made outside of the contract such as management presentations, data room disclosures and projections. The seller’s goal is to eliminate all such extra contractual claims including fraud claims. The buyer, on the other hand, will generally push back that if a seller commits fraud (i.e. intentionally misleads or omits to disclose a material fact) in extra contractual communications, most likely found in projections, the seller should not be able to avoid liability. But how does each accomplish its goals?
Of recent date, the Delaware courts have given guidance on this matter. See IAC Search, LLC v. Conversant LLC; C.A. No. 11774–CB Submitted: September 20, 2016. Decided: November 30, 2016; Anvil Holding Corporation v. Iron Acquisition Company, Inc., C.A. Nos. 7975–VCP, N12C–11–053–DFP [CCLD]. Submitted: April 22, 2013. Decided: May 17, 2013; and TransDigm Inc. v. Alcoa Global Fasteners, Inc., C.A. No. 7135–VCP. Submitted: Feb. 1, 2013. Decided: May 29, 2013.
A seller looking to bar claims based on extra-contractual statements, including fraud claims, should include an affirmative, comprehensive buyer acknowledgement clause with a clear statement that the buyer did not rely on any extra-contractual information, and that no other representations or warranties were made, including with respect to virtual data rooms, due diligence materials, management presentations, etc., unless such information is expressly included in a representation and warranty in the sale agreement. A seller should also include a standard integration clause to compliment the buyer acknowledgement clause to properly limit the documents that constitute the parties’ agreement. A buyer must be diligent when negotiating a buyer acknowledgement clause and should confirm the scope of the acknowledgement to prevent the seller from overreaching. Moreover, a buyer should ask for a specific fraud carve out to preserve its right to claims for fraud based on extra-contractual statements and representations.
A buyer and seller each have compelling arguments for their respective positions and the outcome is found in the art of persuasion and negotiation of the sale agreement terms.
People put their heart and soul into building a successful business. Often, many years of energy, work, and sacrifice lead owners to feel attached to their life’s work in many ways. When it comes time to consider the sale of a closely held business to a private equity fund or other financial firm, this deep level of investment can make such a sale process a very emotional endeavor for the owner. Though the decision might make great business sense, it’s hard for some sellers to say goodbye to something that has been an integral part of their life and identity. As a result, they may experience a mixture of fear, anxiety, sadness, grief, resentment and doubt. These emotions, when elevated, can interrupt a seller’s ability to be rational and effectively navigate the many decisions they will encounter.
So how should a private equity professional approach a potentially fraught negotiation with an emotionally invested seller in order to put together a successful transaction and achieve the best possible result? We asked our good friend, Jodi Coochise, a licensed psychologist and behavioral finance consultant and coach, to recommend her “Top 5 Ways” to approach a tense negotiation with a seller who is struggling emotionally with the decision to sell. Here are few things that you can do and keep in mind when dealing with an emotional seller in order to keep the negotiation grounded, focused and moving in a positive direction.
1. Model calmness. Before the meeting, make sure you are in a calm and relaxed mindset. If you know that the seller is struggling with the potential sale, it will be important for you to go into that conversation with patience and a calm demeanor. Focus on your own breathing, taking deep breaths before, during and after the meeting. Talking a slow, even tone can also help set the tone of the conversation and help the seller regulate their own emotions. As humans we naturally feed off the emotions of others and your relaxed energy will be contagious.
2. Don’t shy away from the emotion. Many professionals feel a strong aversion to emotional expression in their business relationships and try to avoid bringing up the obvious. Naming the emotion isn’t the same thing as turning the negotiation into a “therapy session.” But your willingness to acknowledge the seller’s emotional distress and the fact that it is clearly difficult to part with something that was their life’s work can help them feel more comfortable and reassured.
3. Recognize the value of listening! The goal of these conversations is to reach an agreement, and we can get narrowly focused on the details. However, with an emotional seller, ignoring the feelings can actually elevate their emotional reaction leading to a decrease in openness and lessening their willingness to compromise. Recognize that sometimes we need to slow down and just listen. Trust that they want to get back to business too, but they may just need a few minutes to say how they are feeling. Your acknowledgment and validation can calm them; helping them get back to a more rational mindset. Shifting focus or skipping over it can force them to bottle it up, which can lead to those emotions getting more activated.
4. Highlight motivations. Clarify and discuss the primary reasons for their choice to sell or exit the business. Exploring this in detail helps the seller reaffirm why they are taking this step. And this information will come in handy when the strong doubts, regrets or fear about the future come up. You can echo their words back to the seller, gently reminding them of the important factors that led them to this point and can help de-escalate the emotional reaction.
5. Help prepare them for what comes next. It may be a conversation that goes beyond the immediate sale negotiation, but asking them questions like, “what do you think you will do next?”, “in your first day after the sale is finalized, what do think you will do?” or “how do you think you will feel when this deal is finalized?” is time well spent. By asking these types of questions you are helping the seller start to think about next steps and create a game plan they can turn to when the reality sinks in.
Many thanks to Jodi Coochise for her contribution of this blog post! Jodi received her Ph.D. in Counseling Psychology from Colorado State University. She is a Licensed Psychologist who divides her time between a clinical practice and working in the financial industry. Jodi’s non-clinical work includes consulting with financial advising firms, where she provides coaching for advisors around integrating Behavioral Finance principles into their client interactions.
Private Equity deal flow in the first quarter of 2017 has slowed compared to the end of 2016. The first quarter of 2017 saw 745 transaction closed totaling $118 billion in value compared to 867 deals totally $138 Billion in the final quarter of 2016. It should be noted, however, that 2016 started the same way with a slow first quarter before hitting record highs. Further, while 2017 has seen a slow start to private equity transactions, the fundamentals point to a strong year and fundraising continues to be strong and private equity buyers continue to sit on a record amount of dry powder. As of 2016, private equity funds were sitting on over $500 billion in equity of dry powder.
One of the difficulties in the current private equity market is the continued high multiples that targets are commanding. 2016 saw elevated EBITDA multiples and 2017 has thus far provided more of the same as the median EBITDA multiple for the first quarter of 2017 was 10.8x. These high multiples, coupled with strategic buyers willing to pay top dollar, have challenged private equity funds looking to deploy capital. Strategic buyers continue to pay higher prices due to the fact that they have cash, are looking to boost revenue, and can often take advantage of synergies often not available to private equity buyers.
So while the first quarter of 2017 has been lackluster for many private equity funds in terms of deal value and deal flow, the hope for many private equity investors is that deal flow ticks up in the remaining three quarters of 2017m similarly to what investors saw in 2016.
The effect of technology on the industry
E-commerce and the continuing outperformance of online sales are hitting traditional brick and mortar operations hard. As the merging of online and physical operations presents new challenges, retailers primarily focused on brick and mortar locations are looking to viable e-commerce offerings as a solution for their struggles and, instead of avoiding brick and mortar companies altogether, some acquirers are targeting companies with physical locations that also manage their own e-commerce and websites, as explained by one acquirer at a recent Nixon Peabody LLP private equity roundtable event focusing on consumer products and services in middle market transactions. This move away from brick and mortar companies has been noted across various sectors in the market, including apparel. However, some sectors, including the perishable products and home furnishings spaces, appear to be somewhat protected against digital disruption because consumers still crave the touch and feel factor for these products—they want to access them in person to assess quality and other factors. In 2017, the number of liquidations and bankruptcies among the brick and mortar sector are expected to increase as changing retail industry dynamics and shifting consumer purchasing habits weed out companies that fail to remain relevant and engage consumers.
In addition, many consumer-driven companies are now successfully using augmented reality (AR) technology and AR apps to enrich their customers’ experiences and interactions with their brand, and ultimately to boost sales. This use of technology, such as trying on reading glasses virtually over the internet instead of going into a brick and mortar store to try on and purchase glasses, is here to stay and will continue to change the retail space in the coming years. If a customer cannot experience a product online, it’s likely that such product will be less successful and, in some cases, avoided altogether.
The millennial generation effect
Private equity investors continue to focus on trends both created by and important to the millennial generation, which is steadily gaining more purchasing power. Within the consumer products and services industry, the millennial generation is focused on:
(a) paying for experiences (such as home furnishings and travel), rather than goods;
(b) healthier foods, including transparency around food chain sourcing and whether such production chains are environmentally friendly and, in some cases, come from sources that observe sustainability practices;
(c) paying up for customized offerings blended with an experiential setting and for convenience;
(d) new and different apparel as brand loyalty fades; and
(e) in some cases, the charitable giving practices of the providers of their products and services.
These various trends have caught the attention of private equity investors because private equity investors want to capitalize on this generation’s increasing purchasing power.
The Trump effect
The presidential election victory of Donald Trump, along with the Republican hold of the House of Representatives and Senate, signal changes ahead, including potential tax cuts and changes in trade policies and regulations. Given these potential changes, buyer hesitation across many sectors, including the consumer products and services sector, is reasonable; therefore, a focus on quality and clear established rationales for acquisitions will remain paramount.
Worry exists in the industry about the potential regulatory changes that the Trump Administration has promised to implement, including the potential for an import tax. No one knows what the import tax will be or how or when it would be implemented, and investors at the Nixon Peabody roundtable event are factoring this uncertainty into investment decisions. For example, one investor recently passed on submitting a bid for a target company that had a large number of imports from China but whose largest competitors did not also similarly import its products from China, given the risk of a potential future import tax. Another investor noted that his firm continues to bid on target companies, but requires an escrow of funds for a certain period of time following closing so that the seller bears the risk of potential import taxes and increased labor costs for a certain period of time following the purchase. In addition, changes in trade policies and trade agreements could lead to increased prices for imported goods, which would reduce spending power and lead to job cuts in export sectors.